Form 5471 Penalties: Analyzing the Differing Outcomes of the Farhy and Safdieh Cases

Section 6038(b) of the Internal Revenue Code (IRC) imposes penalties on U.S. taxpayers who fail to file required information returns regarding their foreign business interests. Specifically, this section mandates the filing of Form 5471 by certain shareholders of a “controlled foreign corporation.” The penalties for non-compliance can be substantial, often amounting to $10,000 per violation, with complex penalty continuation rules.

Form 5471 is crucial for the IRS to monitor international tax compliance and prevent tax evasion. By requiring U.S. taxpayers to disclose their foreign holdings, the IRS aims to ensure that income generated abroad is reported and taxed appropriately under the subpart F and GILTI regimes. Failure to file this form can lead to significant financial penalties, making compliance essential for individuals and corporations alike.

In Farhy v. Commissioner, the taxpayer, a U.S. permanent resident, faced penalties for not disclosing his ownership of foreign corporations as required under section 6038(a). The IRS assessed penalties amounting to $10,000 for each year of non-compliance. The taxpayer contested the IRS’s authority to impose these penalties without judicial proceedings, arguing that the IRS lacked the statutory authority to assess them directly.

Initially, the Tax Court sided with the taxpayer, ruling that the IRS did not have the express authority to assess penalties under section 6038(b). The court emphasized that while Congress had authorized penalties under other sections of the IRC, no such explicit authorization existed for section 6038(b). This decision marked a significant departure from the IRS’s long-standing practice of summarily assessing these penalties.

However, the D.C. Circuit Court later reversed the Tax Court’s decision, asserting that Congress intended for these penalties to be assessable. The appellate court examined the legislative history of section 6038 and concluded that the structure and function of the section indicated an implicit authorization for the IRS to assess penalties. This ruling raised questions about the IRS’s administrative practices and the interpretation of statutory authority.

Following the Farhy decision, the Tax Court encountered another case involving similar issues: Safdieh v. Commissioner. In this instance, the taxpayer faced penalties for failing to file Form 5471 for several years. The IRS sought to impose penalties totaling $50,000, but the taxpayer challenged the IRS’s authority to assess these penalties administratively.

In a ruling that echoed its earlier decision in Farhy, the Tax Court once again held that the IRS lacked the authority to assess penalties under section 6038(b). The court reiterated that the statutory language did not provide the IRS with the necessary authority to impose penalties without judicial intervention. This decision reinforced the Tax Court’s stance and created a split in authority between the Tax Court and the D.C. Circuit. Because Safdieh is a New York resident, his case is appealable to the U.S. Court of Appeals for the Second Circuit.

The Tax Court’s ruling in Safdieh has significant implications for taxpayers facing penalties under section 6038(b).

For those located within the favorable circuit, the decision offers potential support in challenging IRS assessments under section 6038(b). Still, it is critical to recognize that the IRS has not accepted this interpretation and continues to assert its authority to assess these penalties. Hence, despite the ongoing legal battles, the requirement to file Form 5471 remains in effect, and taxpayers must continue to comply with international information reporting obligations to avoid penalties.

The recent decisions in Farhy and Safdieh underscore the uncertainty surrounding the IRS’s authority to assess penalties under section 6038(b). The conflicting rulings between the Tax Court and the D.C. Circuit have created a potential circuit split, making the issue ripe for eventual Supreme Court review.

In this environment, taxpayers — particularly those in jurisdictions where favorable rulings have been issued — should remain vigilant about their reporting obligations and may wish to consult with a qualified tax advisor about strategies to preserve their rights. If the Supreme Court were to affirm the taxpayer-favorable approach or determine that the IRS has exceeded its statutory authority, those who have acted proactively will be better positioned to benefit from such developments.

Until there is greater clarity, compliance with IRS requirements remains essential, even as these legal challenges continue to unfold.

Authors: Manpreet Sangha | [email protected] and Marcus Dyer, JD, CPA, Principal and Co-Leader of Tax Controversy | [email protected]